Finance 3310

Financial Statement Analysis

Lecture 3

As we discussed in the previous chapter, financial statements are the primary source of financial data about a company. It is difficult to do much meaningful analysis from the raw financial statements however. Converting the financial statements to cash flow provides useful information. Converting financial statement numbers into ratios also provides a useful way of looking at the data.

T3.5

STATEMENT OF CASH FLOWS

In the last chapter we learned how to convert the financial statements into a `computation' of cash flows. One of the financial statements prepared by accountants is the statement of cash flows. The statement of cash flows provides virtually the same information as the computation we have already learned. The primary differences between the two are format, and the statement prepared by the accountants shows the changes in the components of working capital, while the computation we prepared indicates the change in working capital in total. T3.5 is an example of the statement of cash flows. (Compare T3.5 with T2.10.)

STANDARDIZED FINANCIAL STATEMENTS

We cannot conclude much from the raw financial statement data. It would be helpful to have a benchmark or basis for comparison. The usual basis of comparison is similar companies in the industry (see below), or historical data of the same company. However, because of differences of size direct comparison is not very useful. Size differences are solved by creating `common-size' or standardized financial statements.

• Standardized balance sheet - a common-size balance sheet presents all balance sheet account amounts as a percentage of total assets T3.6 is an example. A look at fixed assets, for example, indicates how much more useful the common-size statements are. (See T3.6)

• Standardized income statement - a common-size income statement presents all account balances as a percentage of sales. T3.7 is an example. Again notice how much more useful the common-size statement is.

• Common-base financial statements - a different way to standardize financial statements is to divide all account balances by the corresponding account's balance in a base year. The result indicates the growth rate of each account, or the trend in each account.

T3.8

RATIO ANALYSIS

Ratio analysis is a very useful tool for analyzing the financial aspects of a company. In fact, the common-size financial statements discussed previously already contain many of the ratios which are specifically examined in ratio analysis. Before computing the ratios, we should recognize several important points:

• What are we trying to measure or analyze? (performance? liquidity?)

• Who is the user?

- supplier

- bondholder

- shareholder

- management: management will be interested in all ratios, though will

emphasize some over others

• What goes into a particular ratio? In general, book value which represents historical cost.

• What is the unit of measurement? Percent of a $, days, turnover?

• What is a `good' or `bad' ratio?

Finally, ratio analysis is a means to an end, not an end in itself. That is, ratio analysis may present more questions than it answers. Why is a particular ratio high or low? Is it transitory, or continuing?

T3.9, T3.10

There are five major groups of ratios. These are:

1. Short-term solvency or liquidity ratios

2. Long-term solvency or financial leverage ratios

3. Asset management or turnover ratios

4. Profitability ratios

5. Market ratios.

Note that who the user is will dictate which particular group of ratios is most important. Many of the ratios are defined differently, not only by accounting and finance textbooks, but sometimes between different finance textbooks. Comparability is most important.

• Short-term solvency or liquidity ratios - indicate ability of corporation to meet its short-term obligations. These are primarily of interest to suppliers and other short-term creditors. See T3.10 for definitions of these ratios.

• Long-term solvency or financial leverage ratios - indicate degree of debt financing by a company, as well as ability to meet long-term obligations. These are primarily of interest to bondholders, and may be of interest to shareholders. See T3.10 II. for definitions of these ratios.

• Asset Utilization or Turnover ratios - indicate intensity and efficiency of asset use. Also called asset management ratios. Of particular interest to management and financial analysts. Total asset turnover may be too broad oftentimes to be useful. The components would be important. See T3.10 III. for definitions of these ratios.

• Profitability ratios - indicate combined use of both assets and debt. These are primarily of interest to management and analysts/shareholders. See T3.10 IV. for definitions of these ratios. Net margin is sometimes too broad, and can mask underlying problems. (Net margin is tainted by the use of debt. See DuPont later.) I would include the following ratios:

Gross margin = gross profit ÷ sales

Operating margin = operating profit ÷ sales

These two ratios are not `tainted' by the financing decisions or tax situation of the company and get at the underlying profitability of the company.

• Market ratios - these ratios incorporate both financial statement information and market-based information. These reflect market perceptions of company performance and market expectations of the future. (Recall that accounting numbers reflect the past, while market numbers reflect expectations about the future.) See T3.10 V. for definitions of these ratios.

T3.11

FINANCIAL RATIOS:

LIQUIDITY

• INDICATE THE ABILITY OF THE COMPANY TO MEET ITS CURRENT OBLIGATIONS

• OF INTEREST TO SHORT-TERM CREDITORS; BANKS

1. CURRENT RATIO ---- CURRENT ASSETS / CURRENT LIABILITIES

• ABILITY OF FIRM TO MEET CURRENT OBLIGATIONS WITH CURRENT ASSETS.

• WHAT IS A GOOD CURRENT RATIO?

2. QUICK RATIO ---- (CUR. ASSETS - INV) / CURRENT LIABILITIES

• ABILITY TO MEET CURRENT OBLIGATIONS W/O HAVING TO LIQUIDATE INVENTORY.

• INVENTORY CONSIDERED LEAST LIQUID

ACTIVITY RATIOS

• INDICATE HOW WELL COMPANY IS EMPLOYING ITS ASSETS

• BAD MGMT ==> EXECESS FINANCING

BAD DEBTS

OBSOLETE INVENTORY

• THESE RATIOS ARE OF PRIMARY INTEREST TO ANALYSTS AND MANAGEMENT

1. ASSET TURNOVER ---- SALES / TOTAL ASSETS

• MAY USE AVG. OF BEG. AND END. ASSETS

• MAY USE MONTHLY AVERAGE (SEASONAL CO)

• INDICATES # OF DOLLORS OF SALES GENERATED FROM A $ OF ASSETS; OR CONVERSELY, THE DOLLARS OF ASSETS NEEDED TO GENERATE A $ OF SALES

• DEPENDS ON AGE & NATURE OF BUSINESS

• MAY NOT DETECT PROBLEMS

 

2. INVENTORY TURNOVER ---- COST OF SALES / INVENTORY

• MAY USE AVG. INVENTORY INSTEAD

• INDICATES HOW OFTEN INVENTORY `SELLS OUT' PER YEAR

• CLEARLY AN IMPORTANT RATIO FOR MGMT

2A. DAYS SALES IN INVENTORY ---- 365 / INV. TURN

• AVG # OF DAYS OF SALES BEING HELD IN INVENTORY; SAME INFO AS INV. TURN

 

3. DAYS SALES OUTSTANDING ---- ACCTS. REC. / SALES/365

• MAY USE AVERAGE RECEIVABLES

• INDICATES AVG. # OF DAYS OF SALES WHICH ARE STILL UNCOLLECTED

• INDICATES HOW LONG, ON AVG., IT TAKES TO COLLECT A SALE

• USEFUL FOR PRO-FORMA'S

• CLEARLY IMPORTANT TO MGMT

 

LEVERAGE RATIOS

• MEASURE THE USE OF DEBT FINANCING

• ABILITY OF FIRM TO MEET FIXED DEBT PYMTS

• IMPORTANT TO LONG-TERM CREDITORS

 

FINANCIAL LEVERAGE - THE USE OF DEBT FINANCING, WHICH HAS THE EFFECT OF MAGNIFYING

(LEVERING) POSSIBLE OUTCOMES.

• CONTRAST WITH OPERATING LEVERAGE

• IS DEBT FINANCING GOOD OR BAD?

 

1. DEBT RATIO ---- TOTAL DEBT / TOTAL ASSETS

• SOME DEFN'S EXCLUDE CURRENT LIAB.

• SOME DEFN'S USE ONLY LONG-TERM DEBT

• MEASURES % OF FUNDS SUPPLIED BY CREDITORS

ALSO:

DEBT/EQUITY

ASSETS/EQUITY (EQUITY MULTIPLIER)

2. TIMES INTEREST EARNED - EBIT / INTEREST EXP.

• MEASURES ABILITY OF FIRM TO MEET INTEREST PAYMENTS

 

2A. CASH COVERAGE RATIO - EBIT + NONCASH EXP / INTEREST EXP.

• MEASURES ABILITY OF FIRM TO MEET INTEREST PAYMENTS FROM A CASH FLOW STANDPOINT

• PARTICULARLY IMPORTANT FOR HIGHLY LEVERAGED COMPANIES

 

3. DAYS PAYABLE O/S - ACCOUNTS PAYABLE / (C.O.S./365)

• INDICATES HOW QUICKLY CO. PAYS ITS BILLS

• INDICATES # DAYS OF PURCHASES STILL UNPAID

• ANALOG TO DAYS SALES O/S

 

PROFITABILITY RATIOS

• INDICATE HOW PROFITABLE THE FIRM IS; THEY MEASURE THE COMBINED EFFECT OF ASSET AND DEBT MANAGEMENT

1. PROFIT MARGIN ---- NET INCOME / SALES

• SOMETIMES CALLED `NET MARGIN'

• INDICATES % OF A SALES $ WHICH REACHES THE BOTTOM LINE; PROFIT PER $ OF SALES

• LIKE TOTAL ASSET TURNOVER, IT MAY NOT REVEAL UNDERLYING PROBLEMS

2. GROSS MARGIN ---- GROSS PROFIT / SALES

• INDICATES UNDERLYING PROFITABILITY OF PRODUCTION PROCESS

• WHAT CAUSES GROSS MARGINS TO CHANGE?

3. OPERATING MARGIN ---- OPERATING PROFIT / SALES

• INDICATES PROFITABILITY, ALLOWING NOT ONLY FOR PRODUCTION, BUT ALSO ALL OTHER COSTS ASSOCIATED WITH MKTG, ACCTG, ADMIN. ETC.

• PROFITABILITY W/O REGARD TO TAX SITUATION AND LEVERAGE

 

4. RETURN ON ASSETS (ROA) ---- NET INCOME / TOTAL ASSETS

• INDICATES PROFITABILITY OF ASSETS

• USING EBIT, OR EBIT AFTER TAXES PROBABLY MAKES MORE SENSE (SEE ROIC BELOW)

• MAY USE AVERAGE OR BEGINNING ASSETS

5. RETURN ON EQUITY (ROE) ---- NET INCOME / EQUITY

• INDICATES WHAT S/H EARNED ON THE BOOK VALUE OF THEIR INVESTMENT

• MAY USE AVERAGE OR BEGINNING EQUITY

• DO NOT CONFUSE W/ RETURN ON INVESTMENT

 

6. RETURN ON INVESTED CAPITAL (ROIC) ---- EBIT(1-t) / (DEBT + EQUITY)

• INDICATES RETURN ON ALL INVESTED CAPITAL

• NOT DISTORTED BY THE USE OF FINANCIAL LEVERAGE

• MEASURES ECONOMIC EARNING POWER OF COMPANY

 

DUPONT ANALYSIS

DuPont analysis is useful for determining the components of ROE. That is, what `drives' ROE.

(1). HOW MANY $SALES CAN BE SQUEEZED OUT OF EVERY $ OF ASSETS

(2). HOW MUCH OF EACH $SALES GETS TO N.I.

(3). HOW MUCH HAS THIS BEEN LEVERAGED

Companies may have similar ROE's for very different reasons. Consider a very operationally efficient company with no debt and an average operationally efficient company with moderate to significant debt.

Other Caveats about ratio analysis

• Inflation can have a distortionary effect on ratios. As an example, consider the effect of inflation on total asset turnover for a capital intensive company.

• Timing problems. Most ratios are calculated using the year-end financial statements. If the year-end numbers are not `representative' of the whole year, then neither are the financial ratios. For example, a very large credit sale at year end could inflate accounts receivable and create a high `days sales outstanding' ratio, implying a slower collection period. Similarly distortions occur with accounts payable and inventory. Companies with seasonal operations are particularly prone to this problem. Finally, different accounting methods can distort ratios. One way to solve this problem is to use average asset balances. Whether or not to solve the problem depends on what you are doing with the ratios and what you are comparing them to. T3.13 represents a good illustration of these comments.

• Comparability. Financial statements cannot be examined in a vacuum. There must be some benchmark for comparison, whether that benchmark is historical data or industry data. Comparability should be the guiding principle in determining how to do financial ratio analysis and how to interpret the results.

T3.12

RATIO COMPARISON ACROSS INDUSTRIES

The exercise presented in T3.12 is particularly useful for understanding and interpreting financial ratios. You are given five sets of common-size balance sheets and financial ratios and must match them with the industries listed below.

Electric Utility

Retail Jeweler

Auto Manufacturer

Japanese Trading Company

Supermarket Chain

In matching the industry with the ratios, consider in particular how you would expect the balance sheet (specifically common-size balance sheet) and various profitability ratios to appear for each of the industries. As an example, I would not expect the balance sheet for a law firm to contain a significant amount of inventory.

Problems:

PEER GROUP ANALYSIS

As stated previously, raw financial statements or financial ratios in isolation are of limited value. They are most useful when they can be compared to historical data or industry data. Comparison with industry data is sometimes called `peer group analysis.' The first step is to identify the appropriate peer group or industry. Conceptually, this means selecting a group for comparison which has the same type of assets contained in the `circle' in our picture of the firm. Practically, these means selecting companies having the same SIC code. SIC code means Standard Industrial Classification code, and these codes are four digit codes established by the US government for statistical reporting purposes by companies. Table 3.9 in your text contains examples for the first two digits of the SIC codes. There are many sources of industry data available in the library and on internet.

Problems: Self test problems 2,3 & 4; Concept questions 4,7,9,10

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